CHAPTER 15 15-1 SUBSTANTIVE TESTS OF OWNERS’ EQUITY ACCOUNTS (a) Procedures applicable to the existence or occurrence of shareholders’ equity balances are: (1) review authorizations and terms of share issues, (2) confirm shares outstanding with registrar and transfer agent, (3) inspect share certificate book, and (4) inspect certificates of shares held in treasury (b) Procedures applicable to rights and obligations are (1) make inquiries of legal counsel, and (2) review articles of incorporation and by-laws 15-2 In vouching dividend entries, the auditor should (a) establish that preferential or other rights of shareholders and any restrictions on dividend distributions have been recognized, (b) establish the number of shares outstanding on the date of record and verify the accuracy of the total dividend declaration by recalculation, (c) ascertain the propriety of the entry to record the declaration, and (d) trace dividend payments to canceled checks and other documentation 15-3 The procedures consist of: (a) review minutes of board of directors’ meetings and (b) compare statement presentation with GAAP 15-4 Earla Company a (1) Certificates may have been surrendered in exchange for others without attaching the surrendered certificates to the stub book (2) The excess certificates may have been issued under proper authority for services or for property and not recorded in the financial books (3) They may have been issued improperly in exchange for cash, services or property, or without consideration The impropriety might result from oversight or from fraudulent design (4) The error may have occurred because an item which should have been posted to the share capital account was not in fact so posted (5) An error may have occurred in entering the number of shares issued on the certificate stub (6) Additional shares may have been issued near the end of 2006 but the cash received was not recorded until 2007 15-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition b (1) Make a quick inspection of open stubs to determine whether they provide a ready clue to the reason for difference, e.g., one certificate issued for 10,000 shares If so, investigate the facts regarding its issue (2) If a quick inspection fails to provide a clue, refer to a list of shareholders supporting the entries in the cash receipts book for the 72,000 shares originally sold Check this list item by item against stubs for shares originally issued and mark the stubs so checked Then check returned certificates attached to stubs against new stubs issued in exchange for those certificates, marking the new stubs Prepare a list of unmarked stubs This should total 10,000 shares and serve to identify the outstanding certificates with respect to which shares are not recorded in the general ledger (3) If errors are found in the number of shares issued, as shown by stubs in the share certificate book after comparison with the cash receipts entries, it may be necessary to circularize the original shareholders to determine how many shares were actually issued The cash receipts book and general journal for the first few days of 2007 should be examined for entries which may be for shares issued late in 2006 (4) If it is found that excess shares have been issued, inquiry should be made of responsible officers with respect to the circumstances in which they were issued The answers obtained should be substantiated by appropriate evidence, e.g., resolutions of the board, etc 15-5 The proposal for the limitation of procedure is not justified by the stated facts Although the transfer agent and the registrar know the number of shares issued, they not necessarily know the number of shares outstanding Furthermore, the audit of share capital includes more than determining the number of shares outstanding For example, the auditor must determine what authorizations exist for the issuance of shares, what assets were received in payment of shares, how the transactions were recorded, and what subscription contracts have been entered into Confirmation from the registrar could not help in determining these things In addition to confirmation from the registrar, the audit of share capital might include the following procedures for which the purposes are briefly indicated: (1) Examine the corporation charter to determine the number of shares authorized and the special provisions relating to each class of shares if more than one class is authorized (2) Examine minutes of shareholders’ and directors’ meetings to determine authorization for appointments of the registrar and the transfer agent, and to determine authorization for the issuance or reacquisition of shares (3) Examine provisions relating to share capital in the corporation law of the state of incorporation to determine any special provisions such as, for example, those relating to the issuance of no-par shares Substantive Tests of Owners’ Equity Accounts 15-3 (4) Analyze the share capital accounts to obtain an orderly picture of share transactions for use as a guide to other auditing procedures and as a permanent record (5) Trace the consideration received for share capital into the records to determine what consideration has been received and how it has been recorded (6) Examine and schedule treasury shares and review entries for treasury shares to determine the existence of treasury shares, as authorized, and to determine that a proper record has been made (7) Review registrar’s invoices and cash disbursements to determine that original issue taxes have been paid (8) Compare dividends with shares outstanding at dividend dates to determine that dividends have been properly paid and also to substantiate the shares outstanding (9) Review subscription and option contracts, etc., to determine the facts in regard to subscriptions and options and to determine that these facts have been properly recorded and that they are adequately disclosed 15-6 Talisay Corporation Based on the limited data made available in the problem, the Balance Sheet is presented as follows: Talisay Corporation Balance Sheet December 31, 2006 Assets Current assets (including share subscriptions receivable) Noncurrent assets Land Other fixed assets (net of accumulated depreciation of P16,000) Total assets P 34,000 9,000 40,000 P 83,000 Liabilities and Shareholders’ Equity Current liabilities Long-term liabilities Total liabilities Shareholders’ equity 10% Preference shares (P10 par value; 1,000 shares authorized, issued, and outstanding) Ordinary shares (P2 par value; 4,500 shares authorized, 4,000 shares issued, and 3,250 outstanding) Ordinary shares subscribed (500 shares) P 20,000 8,000 P 28,000 P 10,000 8,000 1,000 a 15-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition Paid-in capital in excess of par (preference) Paid-in capital in excess of par (ordinary) Donated capital Retained earnings Less: Treasury shares (750 shares at cost) 2,000 20,250 b 9,000 19,750 c (15,000) d Total liabilities and shareholders’ equity _ a 500 shares x P2 par value = P1,000 P 83,000 b Amount on issued ordinary shares [P18,000 - (4,000 x P2)] Amount on subscribed ordinary shares [P10,000 - (500 x P2)] Sale of treasury shares (250 x P25) Cost of treasury shares sold (250 x P20) 15-7 P10,000 9,000 P19,000 P 6,250 ( 5,000) 1,250 P20,250 c P20,000 - P1,250 (improper gain) + P1,000 (improper loss) P19,750 d P15,000 total cost ÷ P20 cost per share = 750 shares Hope, Inc Hope, Inc Shareholders’ Equity As of September 30, 2007 P2 Cumulative redeemable preference shares (P15 par value; 500,000 shares authorized; 8,000 shares issued and outstanding) Ordinary shares (P10 par value; 1,000,000 shares authorized, 114,500 shares issued, 110,000 shares outstanding) Ordinary shares subscribed, 10,000 shares Paid-in capital in excess of par (ordinary) Discount on preference shares Retained earnings Treasury shares (4,500 shares at cost) P 120,0000 1,145,000 100,000 217,500 (20,000) 671,000 (121,500) P2,112,000 (a) Balance 9/30/06 Shares issued to purchase land Shares redeemed Preference Shares Schedule # of Shares Amount 4,000 P 60,000 8,000 120,000 (4,000) (60,000) Substantive Tests of Owners’ Equity Accounts Balance 9/30/07 (b) 8,000 15-5 P120,000 Ordinary Shares Schedule # of Shares Amount 110,000 P1,100,000 4,500 45,000 114,500 P1,145,000 Balance 9/30/06 T Santos Balance 9/30/07 (c) Balance 9/30/06 Sale to T Santos [4,500 x (P25 - P10)] Subscription by K Reyes [10,000 x (25 - P10)] Paid-in Capital Schedule Amount -0P 67,500 150,000 P217,500 (d) Retained Earnings Schedule Amount Balance 9/30/06 P622,000 Net income 250,000 Preference shares redemption [4,000 x (P18 ( 12,000) P15)] Cash dividend – ordinary (110,000 x P1.50) (165,000) Cash dividend – preference (12,000 x P2) ( 24,000) P671,000 15-8 Baguio Company Baguio Company Shareholders’ Equity December 31, 2007 Ordinary shares (15 par value; 100,000 shares authorized, and outstanding) Paid-in capital in excess of par Retained earnings (from Dec 31, 2007) P1,500,000 2,425,000 * -0- Total Shareholders’ Equity P3,925,000 * Original balance P1,750,000 Reduction of par value of ordinary shares (P10 x 100,000) 1,000,000 Additional contribution 600,000 Elimination of deficit (925,000) ** Paid-in capital in excess of par P2,425,000 ** Original deficit P750,000 15-6 Solutions Manual to Accompany Applied Auditing, 2006 Edition 15-9 Loss on revaluation of plant assets Deficit to be eliminated Parañaque Company 175,000 P925,000 Retained Earnings before adjustments Add (Deduct) Adjustments: P 131,000 (a) Premium on share capital credited to retained earnings (P 15,000) (b) Gain on sale of treasury shares incorrectly charged ( (c) Appraisal increase of land incorrectly credited to Retained Earnings ( 30,000) 10,000) Total adjustments P( 55,000) Retained Earnings after adjustments P 76,000 Answer: a 15-10 1) c 2) b 3) c 4) a 15-11 A4 Corporation 5) d 6) a 7) c 8) b 9) b 10) d Requirement (1) Part a The legal capital is P417,000 (P210,000 + P207,000) The average issuance price of the preference share is P109 per share [(P210,000 + P18,900) ÷ 2,100 shares] The number of ordinary shares issued is 9,000 shares (P207,000 ÷ P23) Requirement (2) Part b A4 Corporation Contributed Capital Section of the Balance Sheet December 31, 2006 Contributed Capital 8% Preference shares, P100 par (6,000 shares authorized, 2,550 shares issued and outstanding) Ordinary shares, no par 24,000 shares authorized, 10,800 shares issued and outstanding) Premium on preference shares Additional paid-in capital from share subscription default Additional paid-in capital from treasury shares P255,000 266,050 * 27,850 ′ 100 1,000 Substantive Tests of Owners’ Equity Accounts Total contributed capital 15-7 P550,000 * P207,000 + P29,700 + P13,600 + P15,750 = P266,050 ′ P18,900 + P8,800 – P1,100 + P1,250 = P27,850 The above schedule is supported by the following entries for the transactions that occurred in 2006: 2006 Mar Apr 13 May June Oct 19 Cash (P10 x 400) Subscriptions Receivable (P112 x 400) Preference Shares Subscribed (P100 x 400) Premium on Preference Shares 4,000 44,800 Cash (P33 x 900) Ordinary Shares, no par (900 shares) 29,700 Land (P34 x 400) Ordinary Shares, no par (400 shares) 13,600 Cash (P112 x 350) Preference Shares Subscribed (P100 x 350) Subscriptions Receivable Preference Shares, P100 par 39,200 35,000 Preference Shares Subscribed (50 x P100) Premium on Preference Shares (50 x P22) Subscriptions Receivable (50 x P112) Cash (50 x 0.8 x P10) Additional Paid-in Capital from Share Subscriptions Default 5,000 1,100 40,000 8,800 29,700 13,600 39,200 35,000 5,600 400 100 Treasury Shares – Ordinary Cash (500 x P37) 18,500 Cash Ordinary Shares, no par (500 shares) Preference Shares, P100 par Premium on Preference Shares 27,000 500 x P35 (500 x P35) + (100 * Ordinary shares: P27,000 x x P125) 100 x P125 (500 x P35) + (100 x P125) 18,500 15,750* 10,000 1,250 = P15,750 15-8 Solutions Manual to Accompany Applied Auditing, 2006 Edition Preference shares: P27,000 x Nov.16 Dec.31 = P11,250 P27,000 Cash (P39 x 500) Treasury Shares Additional Paid-in Capital from Treasury Shares 19,500 Retained Earnings Cash 21,600* 18,500 1,000 21,600 * Ordinary dividends: (9,000 + 900 + 400 + 500) x P2 = P21,600 31 * 15-12 Retained Earnings Cash 20,400* 20,400 Preferred dividends: (2,100 + 350 + 100) x (0.08 x P100) = P20,400 Partner Corporation Partner Corporation Shareholders’ Equity December 31, 2006 Share capital Preference shares, P4 cumulative, par value P50 per share; authorized 50,000 shares, issued and outstanding 10,000 shares Ordinary shares, par value P1 per share; authorized 500,000 shares, issued 150,000 shares, and outstanding 140,000 shares Total share capital Additional paid-in capital – ordinary In excess of par value From sale of treasury shares Total paid-in capital Retained earnings Accumulated other comprehensive income (loss) Unrealized decrease in value of available for sale securities Total paid-in capital, retained earnings, and accumulated other comprehensive income (loss) Less: Treasury shares, 10,000 shares at cost Total shareholders’ equity P 500,000 150,000 P 650,000 1,560,000 250,000 P2,460,000 231,000 (25,000) P2,666,000 (180,000) P2,486,000 Substantive Tests of Owners’ Equity Accounts 15-13 15-9 Del-V Company Requirement (1) Del-V Company Statement of Retained Earnings For Year Ended December 31, 2006 Retained earnings, as previously reported, January 1, 2006 Less: Correction of overstatement of previous net income (net of P5,400 income tax credit) Adjusted retained earnings, January 1, 2006 Add: Net income Less: Cash dividends Share dividends Reduction due to retirement of preference shares Retained earnings, December 31, 2006 (See Note A) P206,000 (12,600) P193,400 58,000 P251,400 P 9,000 6,000 40,000 (55,000) P196,400 Requirement (2) Note A: Retained earnings are restricted in the amount of P14,000, the cost of the ordinary shares being held as treasury shares 15-14 RICY Corporation Requirement (1) a Write-down of property and equipment Retained Earnings (P80,000 – P45,000) Accumulated Depreciation b 35,000 Write-down of inventories Retained Earnings Current Assets (inventories) c 35,000 6,000 6,000 Write-down of accounts receivable Retained Earnings Current Assets (accounts receivable) 3,000 3,000 15-10 Solutions Manual to Accompany Applied Auditing, 2006 Edition d Change in par value of ordinary shares Ordinary Shares, P10 par Ordinary Shares, P1 par Additional Paid-in Capital on Ordinary Shares e 100,000 10,000 90,000 Elimination of retained earnings deficit Additional Paid-in Capital on Ordinary Shares Retained Earnings * 114,000 114,000 * P114,000 = P70,000 deficit + P35,000 + P6,000 + P3,000 Requirement (2) RICY Corporation Balance Sheet December 31, 2006 Current assets Property and equipment Less: Accumulated depreciation Total assets P 11,000 110,000 (65,000) P 56,000 Liabilities Ordinary shares, P1 par Additional paid-in capital on ordinary shares Retained earnings (see Note A) Total liabilities and shareholders’ equity P 30,000 10,000 16,000 P 56,000 Notes to Financial Statements Note A: Retained earnings as of December 31, 2006 has a zero balance due to a quasi-reorganization on that date At that time, net assets were revalued, the par value of ordinary share was reduced from P10 to P1 per share, and a P114,000 deficit was charged against additional paid-in capital 15-16 JTC Company Requirement (1) Substantive Tests of Owners’ Equity Accounts Preference P20,000 a Preferred dividend (2,000 x 0.10 x P100) Remainder to ordinary (P80,000 – P20,000) P20,000 P40,000 20,000 P60,000 20,000 Total P60,000 c Dividends in arrears (1 x 2,000 x 0.10 x P100) Current preferred dividends Ordinary proportional share (0.10 x 30,000 x P10) Remainder shared * (P80,000 – P70,000) Total P20,000 P20,000 20,000 4,000 P44,000 2,000 x P100 * Preference: P10,000 extra dividend x x P100) + (30,000 x P10) (2,000 P300,000 * Ordinary: P10,000 extra dividend P500,000 x P30,000 6,000 P36,000 = P4,000 = P6,000 d Preference dividend Ordinary proportional share (0.10 x 30,000 x P10) Preference extra (0.05 x P200,000) Ordinary extra (0.05 x P300,000) Remainder to ordinary (P80,000 – P75,000) P20,000 P30,000 10,000 15,000 5,000 P30,000 Requirement (2) = Ordinary P60,000 Total b Dividends in arrears (2 x 2,000 x 0.10 x P100) Current preferred dividend (2,000 x 0.10 x P100) Remainder to ordinary (P80,000 – P60,000) Dividend yield 15-11 Dividends per share Market price per share Preference share: P20,000 / 2,000 P125 = P10 P125 = 8% Ordinary share: P60,000 / 30,000 P20 = P2 P20 = 10% P50,000 15-12 15-16 Solutions Manual to Accompany Applied Auditing, 2006 Edition Empire Plastics Rate of return on ordinary share equity: P213,718 P875,000 + P375,000 = P213,718 P1,250,000 = 17.1% P135,000 = 13.5% P1,000,000 Emporia Plastics, Inc is trading on the equity successfully, since its return on ordinary share equity is greater than interest paid on bonds Rate of interest paid on bonds payable: 15-17 MLA Corporation MLA Corporation SHAREHOLDERS’ EQUITY December 31, 2007 Paid-in Capital: Preference shares, P100 par value 10,000 shares authorized, 4,000 shares issued & outstanding Ordinary shares, P50 par value 15,000 shares authorized, 8,000 shares issued 7,700 shares outstanding Additional Paid-in Capital: Paid-in capital in excess of par— preference Paid-in capital in excess of par— ordinary Paid-in capital from treasury shares— preference Total Paid-in Capital Retained Earnings: Less cost of treasury shares (300 shares—ordinary) Total Shareholders’ Equity *P610,000 – P312,600 – (P62 X 1,000 shares) P400,000 400,000 P 800,000 52,000 61,000 4,700 117,700 917,700 235,400* 1,153,100 19,800 P1,133,300 Substantive Tests of Owners’ Equity Accounts 15-18 15-13 Odyssey, Inc (a) Basic formulas: Value of bonds without warrants Value of bonds without warrants + Value of warrants X Issue price = Value assigned to bonds Value of warrants Value of bonds without warrants + Value of warrants X Issue price = Value assigned to warrants P136,000 P136,000 + P24,000 X P152,000 = P129,200 Value assigned to bonds P24,000 P136,000 + P24,000 22,800 X P152,000 = P152,000 Cash Discount on Bonds Payable (P170,000 – P129,200) Bonds Payable Paid-in Capital—Share Warrants Value assigned to warrants Total 152,000 40,800 170,000 22,800 (b) When the warrants are non-detachable, separate recognition is not given to the warrants The accounting treatment parallels that given convertible debt because the debt and equity element cannot be separated The entry if warrants were non-detachable is: Cash Discount on Bonds Payable Bonds Payable 15-19 152,000 18,000 170,000 Simmy Corporation Requirement (a) Net income for year Add: Adjustment for interest (net of tax) * Maturity value Stated rate Cash interest P9,500,000 234,000* P9,734,000 P5,000,000 X 7% 350,000 15-14 Solutions Manual to Accompany Applied Auditing, 2006 Edition Discount amortization [(1.00 – 98) X P5,000,000 X 1/10] Interest expense – tax rate (35%) After-tax interest 10,000 360,000 X 0.65 P 234,000 P5,000,000/P1,000 = 5,000 debentures Increase in diluted earnings per share denominator: 5,000 X 18 90,000 Earnings per share: Basic EPS Diluted EPS P9,500,000 ÷ 2,000,000 = P4.75 P9,734,000 ÷ 2,090,000 = P4.66 Requirement (b) If the convertible security were preference shares, basic EPS would be the same assuming there were no preference dividends declared or the preference was noncumulative For diluted EPS, the numerator would be the net income amount and the denominator would be 2,090,000  ... made of responsible officers with respect to the circumstances in which they were issued The answers obtained should be substantiated by appropriate evidence, e.g., resolutions of the board, etc... certificates with respect to which shares are not recorded in the general ledger (3) If errors are found in the number of shares issued, as shown by stubs in the share certificate book after comparison with. ..15-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition b (1) Make a quick inspection of open stubs to determine